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It's finally starting to happen: After five years of extraordinarily defensive investing, the nation's largest wealth-management firms are growing wary of bonds and more upbeat on stocks.

On average, the wealth managers are recommending that investors put 29% of their money in fixed income, down from 34% a year ago, according to an annual survey by Penta. The managers and their clients are increasingly worried that interest rates will start to rise, a development that would hurt bond values.

At the same time, wealth managers are recommending an average allocation to stocks of 48%, up from 45%, reflecting increased optimism about the U.S. and beyond. Many expect to step up their equity allocations still further as the year progresses.

"The world hasn't collapsed, and there's a beginning of a normalization in the way we look at the markets," says Chris Wolfe, chief investment officer at Merrill Lynch Wealth Management.

Wealth pros are charting courses away from bonds, wary of interest rates.
James Bennett for Barron's

The shift could put the wealth-management industry at the forefront of "the great rotation" -- a long-awaited move by investors out of bonds and into stocks. Data on mutual-fund flows in the first weeks of the new year suggested that the rotation was starting to happen, with net inflows into stock funds running at a vigorous $29.5 billion a month.

Wealthy investors appear to be heeding their managers' advice, which itself is a big change. In the past few years, portfolio managers have periodically urged their clients to become more risk-tolerant and more open to equities, but their clients wouldn't budge. Still rattled by the recession of 2008, they resolutely ignored their bankers' advice.

"We are in the initial stages of investor psychology changing," says Chris Hyzy, chief investment officer at U.S. Trust. "Right now the change has more to do with concern over rising interest rates than a positive view toward stocks." But the shift toward stocks will become more pronounced "when investors realize a secular bull market will be the story for the next three to five years," he says.

The Penta survey, carried out in January and February, was based on the "model portfolios" from 40 of the largest wealth-management businesses -- a mix of banks, trust companies, and investment firms. Model portfolios often are the starting point of discussions with clients; eventually the wealth managers and clients settle on more custom-tailored allocations. A complete table of the recommendations appears here.

In addition to cutting back on bonds, many wealth managers in our survey are sharply reducing their holdings of cash. LPL Financial, a large federation of some 13,000 independent advisors, has whacked its recommended cash position in half since last year, to 10%. HSBC Private Bank took cash from 6% to 1%.

Instead of bonds and cash, the managers and their clients are finding ballast in alternative investments like hedge funds, commodities, and real estate. Barclays has upped alternative assets to 28% of its model portfolio from 23% last year. Brown Advisory of Baltimore now has 27%, an increase of eight percentage points.

It's not that wealth managers are ignoring the big risks posed by Europe's banks, the U.S. debt crisis, and tensions in the Middle East. They remain keenly aware of the dangers but have subtly changed their point of view: "We now see the glass as half-full rather than half-empty," says Gordon Fowler, CEO of Glenmede, an independent investment firm based in Philadelphia.

IN THE RETURN TO EQUITIES, wealth managers and their clients often are pointing their vessels toward foreign waters. After firms such as Citi Private Bank, Morgan Stanley, and Atlantic Trust slashed foreign exposure by as much as 40% two years ago, the global push is back. The average exposure to foreign stocks is now close to 18%, up from a low of 13% in last year's third quarter.

"For the past couple of years, the U.S. economy was the cleanest shirt in the hamper, but now risks have receded considerably related to Europe's sovereign debt crises and whether China and other emerging markets could avert a hard landing," says Mark Luschini, chief investment strategist at brokerage Janney Montgomery Scott.

In some cases, shifts into foreign holdings have been dramatic: Constellation Wealth, an independent New York-based firm, had 20% in foreign stocks in early 2011; 10% a year later; and recently, 25%. Multifamily office GenSpring went from 13% to 8% and then up to 23%. Private-banking stalwart Northern Trust had 13% in 2011, pared to 10%, and now holds 23%. Wilmington Trust, UBS, Neuberger Berman, HSBC, and Atlantic Trust also have developed a robust appetite for foreign stocks.

Three-quarters of managers surveyed increased their non-U.S. developed-stock exposure, but particularly to Europe. Despite a surprising surge of 15% in European stocks last year, developed Europe still may have room to run: It's valued at about 14 times earnings, compared with 16 times earnings for the Russell 3000, a broad U.S. index, says Ryan Dimas, William Blair's director of open-architecture research

Japan is also attracting more interest -- and assets -- since Shinzo Abe became prime minister in December and unveiled a $117 billion fiscal-stimulus package, his attempt at trying to reverse the nation's chronic deflation and finally unleash some serious growth. Valuations in Tokyo are appealing, and if Abe's efforts to devalue the yen are successful, you could see exports pick up and a resulting earnings bump, says Bill Ebsworth, chief investment officer of Fidelity's global asset allocation group.

Not everyone has gone all ninja on the Nikkei. "Creating a policy of inflation for Japan is junk science," says Jeff Weniger, senior investment analyst of BMO Private Bank, formerly known as Harris Private Bank. "It's spending $3 for every $1 it taxes. Don't forget that two months ago, Abe was talking about getting to 3% inflation, and now it's 2%. It's going to be trouble for them."

The best play in those parts? Paul Chew, Brown Advisory's head of investments, likes small-cap emerging-market stocks. "It's the middle-class consumption story that makes emerging markets attractive. You really have to dive down into the smaller companies to get the heavy exposure in the consumption story," he says.

U.S. STOCKS ARE PERCEIVED mostly positively, the result of a 2.5% expected annual GDP growth this year. That lags behind the average historical 3.2% growth, but it's ahead of last year's, which explains why more than half of our wealth managers have added to their large-cap U.S. stock positions over the past year.

The markets here are still decently priced, many wealth managers say. "Historically, the equity market hasn't peaked until the upper quartile of valuation. Right now, we are at average levels," says Neeti Bhalla, Goldman Sachs Private Wealth Management's head of tactical allocation. The price-to-earnings multiple of the Dow Jones Industrial Average now stands at 13.

While large dividend payers are still the top play, value stocks are coming back into favor, says Bruce McCain, chief investment strategist at Cleveland-based Key Private Bank. U.S. banks themselves are attractive investments because they're highly leveraged to the housing-market recovery. While the banks are already up 15% from mid-November, they're still trading at just about their book value. What's more, they have strong capital levels and are likely to raise payout ratios after the Federal Reserve's next test of their soundness in March.

With every trend there is, of course, a countertrend. A handful of firms, such as U.S. Bank Wealth Management, William Blair, and UBS, have pared back U.S.-stock exposure and taken their money abroad, concerned that the earnings tail wind in the U.S. is subsiding. "Easy gains of cost-cutting and margin enhancement are harder to achieve," says Scott Clemons, chief investment strategist at Brown Brothers Harriman. "So earnings growth is going to be increasingly reliant on top-line revenue growth. In a nominal GDP environment, that's going to prove hard."

Furthermore, some mighty big waves could soon crash down on U.S. investors. "A very difficult political battle is still building for the next round of fiscal-cliff haggling," says Tim Leach, chief investment officer at U.S. Bank Wealth Management. "We are reasonably positive on U.S. equities, but they will probably react negatively, at the least, during that battle." There is also general concern about how the increased payroll tax is undermining the U.S. economy.

BOND HOLDINGS are unquestionably on the decline. To fund bigger stock positions, two-thirds of our firms have reduced overall fixed-income holdings since a year ago; 75% are, in fact, currently underweight fixed-income positions. William Blair cut its exposure from 30% to 15%; GenSpring has gone from 42% to 23%.

With the 10-year Treasury at about 2%, interest rates would seem to have nowhere to go but up, which makes traditionally safe bond portfolios seem risky. Many strategists foresee rates on the 10-year Treasury yields rising to 2.25% or 2.5% by year's end, as more investors pile into stocks. "That kind of move in Treasury rates was fine 10 to 20 years ago, because you had a high yield to overcome loss in principal," says Wells Fargo's Haverland. "But today you could actually have a negative return on your bond portfolio."

So the bulk of fixed-income assets are in short- to mid-maturity corporate bonds and municipal bonds, but even here, firms have trimmed their sails. "This is the lowest level we've ever had to high grade, with just 21% allocated," down from 31% last year, says David Donabedian, chief investment officer of Atlantic Trust, a unit of mutual funds powerhouse Invesco.

High yield has gotten as tricky as ever. Junk bonds are offering record-low yields between 5% and 6%. But the bonds have some clear appeal -- namely, much lower sensitivity to rising rates than Treasuries. "If you have an interest-rate shock of 100 basis points, you'd lose half as much on the junk bonds," says BMO Private Bank's Weniger.

BMO and many others also like bank loans, because their rates adjust regularly to the London interbank offered rate, or Libor; that means the interest-rate risk is minimal. While they aren't high-quality issues, they sit at the top of the capital structure and are first in line to be paid if a company defaults. "Yields are around 5.2%," says Matt Rubin, chief investment officer at asset manager Neuberger Berman. With junk-bonds yields at about 5.5%, it means "you're getting that floating-rate protection and at almost no cost," he says.

Similar 5% or so yields can be found in emerging-market debt, and 70% of those issues are now considered investment grade. That play is even more attractive in view of the likely appreciation in emerging-market currencies, says Deutsche Bank's chief investment officer Ben Pace. "We're overweight the asset class and longer in maturity than last year."

THE BIG CHALLENGE going forward is how to mitigate portfolio risk, given reduced fixed-income exposure. Enter alternative investments: Average exposure to alternative investments is at 20% this year, the highest level since Penta began its survey. "The question is how to replace the ballast," says Brown Advisory's Chew. His firm uses hedge-fund managers who net out duration risk in fixed-income instruments, but still manage to make money on spreads.

Atlantic Trust's Donabedian likes private-equity deals that extend private loans to companies that are unable to get bank loans and too small to issue bonds. "This is different than a typical private-equity investment, which is illiquid," he says. "With these loans, borrowers pay back interest and principal. You get income on a quarterly or monthly basis. Current yields are 6% to 9%."

Most firms have lightened up on real-estate investment trusts, concerned about their growth prospects. Commodities have a purely diversifying role in most portfolios, with exposure down somewhat from last year and with a slight shift away from gold into mixed holdings.

"We like exposure to industrial metals, which will benefit as economic growth picks up," says Jeff Korzenik, the director of portfolio management at Fifth Third Bank.

Still, Constellation's chief investment officer, Sam Katzman, is recommending 7% quarterly payouts through direct ownership in apartments, partly because of likely tax increases. "The bulk of the payout is protected from taxes because the depreciation shields the income," he says.

Investing in apartments? There's only one way to read that. Risk tolerance is making a comeback.

How'd They Do?

Wealth managers basically accomplished their 2012 goals, which were to protect client assets from monstrous risks while adding to their pile. Strategists made allocations in U.S. bonds and large U.S. stocks with a global reach, figuring those asset classes would best weather an economic downturn. Not a bad call. The S&P 500 returned 16% last year, while investment-grade bond indexes achieved modest single-digit returns.

But, as it turned out, the doomsday scenarios never materialized, and the most-avoided asset classes were among last year's best performers. European stocks, for example, were up 15%, while the region's small-caps were up 25%.

The Pacific region ex-Japan was up almost 20%. Furthermore, most managers scaled back non-U.S. developed stocks around midyear and missed the chance to get the most out of the region's strong run.

A handful of firms acted on Mario Draghi's midyear message that he would do whatever it takes to support the euro, adding to their European exposure. Among those were Atlantic Trust, Bernstein Global Wealth Management, Citi Private Bank, Neuberger Berman, HSBC, and Goldman Sachs.

Similarly, those that hung tight in emerging markets were rewarded. While about one-third of firms scaled back during 2012, some, such as BMO, BNY Mellon, Credit Suisse, Fifth Third Bank, HSBC, and Neuberger Berman, maintained an overweight in emerging markets, which were up 15%.